by Archie M. Richards, Jr.
December 3, 2007

Al writes, "I am shifting my Vanguard mutual funds to make them more like the suggested portfolio in your Website. As a resident of California, should I use Vanguard's California Long-Term Tax Exempt Bond Fund instead of the Long-Term Treasury Bond Fund you recommend?"

Saving taxes is enticing, isn't it, Al? At this writing, the current interest yields of the two funds are almost the same (which I wouldn't have expected). Over the last 5 years, the total yield of the California fund (4.3 percent, including changes in price) is about one point less than that of the Treasurys fund. Over the last 10 years, the California fund is about 1.5 points less. If the reduction in tax is sufficient, perhaps the lower interest is worth it.

Perhaps.

But so far in 2007, the Treasurys (including changes in price) have returned 11.2 percent, while the California bonds have returned only 1.4 percent.

There's a reason for this huge difference: Bond prices move opposite to interest rates. As the rates fall, the prices rise. This year, long-term bond rates have gone down substantially, and long-term Treasury prices have risen accordingly.

Stock prices have fallen a tad - no doubt you've noticed. But Treasury bond prices have gone up, mitigating the pain. This is how asset allocation is intended to work. The lack of correlation reduces the portfolio's volatility. This is especially important when the stocks go down.

In general, the prices of tax-exempt bonds are considerably less volatile than as those of Treasurys. To understand why, assume that California issues new, 30-year bonds that pay interest of 5 percent a year. You buy some of them at par ($1,000 per bond). Each bond pays $50 interest a year.

The terms of the bonds provide that after ten years, California has the option of buying them back. (The bonds are said to be "callable.") California promises to pay 2 percent above par ($1,020 per bond), plus interest to the date of the call.

Ten years after the bonds were initially sold, their maturity is now 20 years. Assume that the interest rate of new, 20-year, tax-exempt bonds has fallen to 3.5 percent.

California therefore sells a new issue of 20-year bonds which pays interest of only $35 a bond. It uses the proceeds to buy back, or call, the 5-percent bonds you own, which pay $50. California saves $15 a year per bond. Yes, the State has to pay an extra $20 a bond to call the old ones, but after a little more than a year, it's ahead.

Now back to the beginning: This time, assume that interest rates rise instead of fall, going from 5 percent to 7 percent. California does not issue a new set of bonds, because that would cost more than it's already paying. Neither does it call your bonds; it just continues paying $50 interest on the older issue.

All this means that if interest rates rise, you're stuck holding a bond whose price has gone down - possibly a lot. But if interest rates fall, you have to sell your bond at only 2 percent above par.

On the downside, your bonds have unlimited volatility. On the upside, the volatility is limited to only about 2 percent. California always wins. You can only lose.

Most municipal and state bonds are callable. Treasurys are not. Treasury prices can rise as well as fall, with no restrictions either way.

Even though the interest from Treasurys may be lower after tax, I still prefer them. The lack of correlation with stocks is particularly important when stock prices fall. This is when you need the Treasurys to rise as much as possible, cutting the volatility of the whole portfolio.

During stock-price declines, easing the pain is vital. Reducing the volatility helps to keep us from selling.

Holding stocks during bear markets is vital. The stocks don't stay down; they rebound. You're wise to own them when they do.